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Whenever someone starts cryptocurrency trading, they always want to make as much profit as possible. This is not surprising, considering the fact that cryptocurrencies are highly volatile, making it possible to gain huge profits in a small amount of time.
Usually making high profits requires a big budget, but not many traders can make such a large investment. Because of this, many traders utilize leverage in order to maximize their profits.
Using leverage can seem a great opportunity as potential profits increase significantly, but whenever something is this good, it usually has some downsides as well. So how can we use leverage in crypto trading, and what are its upsides and downsides? Read our guide to find out about it.
Leverage trading is the act of borrowing funds from the broker. What this means is that you are amplifying your buying and selling power, and can trade with higher capital than your deposit. The amount you can borrow will depend on the exchange you are using. At some exchanges, you can multiply your funds by 10 times, while there are also exchanges that can offer leverage of up to 100 times.
When looking at leverage, it will usually be presented as a ratio. A leverage of 1:10 means 10x leverage, so you can trade with 10 times more funds than you deposited. What this means is that, if you use the leverage of 1:10 and want to open a position worth $5000, you only need to deposit $500, while $4,500 is covered by the broker.
So we know what leverage is, but how does trading with leverage work?
Before using leverage, traders need to deposit a certain amount of funds in their trading accounts as a form of collateral. The amount that traders will need to deposit will depend on the amount of leverage they would like to use.
So if you want to open a position worth $5000 with a margin of 1:10, you will need to deposit $500 as collateral. If leverage is 1:20, the collateral for a $5000 position will be $250, and so on. But you should know that the higher the leverage, the more risks you are taking.
When you use the leverage of 1:10 to open a $5000 position, you might need to deposit more than $500 over time. What we mean by that is that when the market turns against your position, losses will be deducted from your collateral and if this collateral goes down a certain threshold you will receive what is called a margin call.
When you receive a margin call, it means that your collateral went too low and the broker risks losing their own money. Then you will need to add more funds to your account in order to maintain collateral. If you don't do so, a broker will close your position, and if he suffered any losses in that process, a broker will liquidate your other assets to cover the losses. If you don't own any other asset, you will simply go into dept to the broker.
There are many different trading strategies used when trading with leverage, but the most popular among them has to be futures contract trading. Here we will look at two examples of leverage trading using futures.
A long position is the process of trading when you are speculating that the price of an asset is going to rise. Let's look at an example of this happening.
Once again, let's say that you want to open a long position worth $5000 using 1:10 leverage. So you opened this position on Ethereum and deposited $500 as collateral. After opening a position, the price of Ethereum rose by %10, and you closed your position. By doing so, you made a profit of $500, minus leverage fees. If you were to make the same trade without leverage, your $500 deposit would only have generated a profit of $50.
But if things didn't go as planned and instead of gaining 10%, let's say that Ethereum lost 20% of its value. In this case, you will be incurring a loss of $1000, which is higher than your collateral. In this case, your assets will be liquidated, and you will be indebted to the broker.
Trading with short positions is the opposite of going long. In this case, you will be betting that the price of an asset will drop. Let's look at the example.
Once again, you are trading with $5000 with 1:10 leverage and deposited $500 as collateral. Let's say that at the time of your trade the price of 1 ETC was $1000, and you opened a short position with $5000, or 5 ETC. When doing so, you are borrowing 5 ETC from someone and selling it. Once the price drops, you buy back that 5 ETC at a cheaper price and return it, so pocketing the price difference between when you sold it and bought it. So if the price of ETC goes down to $900, you will be able to buy back 5 ETC for $4500, which leaves you with a $500 profit, $450 more than the $50 profit you would have made if not for leverage.
But if the opposite happens and the price of Ethereum goes from $1000 to $1100, you will need to spend $5500 in order to return borrowed ETC, leaving you with $500 losses, which is way more than the $50 you would have lost without leverage.
So looking at previous examples, we can see that leverage can be a double edge sword. The higher potential profits you can make, the higher the chances of you losing large amounts of money. Because of this, it is a must to have some risk management strategy implemented in your trading activities.
The most common, easy, and effective strategy to manage your risks when using leverage trading, is to implement stop-loss and take-profit orders. With these, you can make sure to close your position at your desired price, and also set the limit on how much loss you are willing to take.
When using take-profit orders, you are telling a system to sell your asset once it reaches a certain price point indicated by you. With this, you can be sure that if the price will reach your desired mark, you will make profits and remove the possibility of not being able to sell your assets at the desired profit because you were not watching the market every second.
Stop-loss orders work similarly to take-profit ones, the difference being, here you are indicating the price you wish to sell your asset for if the market goes in the wrong direction. So with a stop-loss, you can choose the maximum loss that you are willing to tolerate and set the stop-loss limit to that marked price. If prices reach that mark, your position will be sold and you will be protected from further losses.
“When you combine ignorance and leverage, you get some pretty interesting results.” - Warren Buffett
Since cryptocurrencies are highly volatile, it is advised to use relatively low leverage if you are not an expert trader or can tolerate huge losses. A leverage of 1:10 can be good enough for most.
100x leverage in crypto means leverage of 1:100. What this means is that broker will borrow funds that will amplify your trading power by 100 times. So if you use the leverage of 1:100 and deposit 100$, you will be able to trade with $10,000.
If you are using leverage and end up making losses, there are two potential things that can happen. If on top of losing your money, you lost the money borrowed by the broker, a broker can liquidate your other assets until he gets his money back. If you don't own any assets, you will simply be indebted to the broker.